Suppose a politician wanted to:
- support the health care industry, which had been generous with financial contributions to that politician’s campaigns;
- to that end, and also to provide Americans with better financial access to health care, grant federal subsidies for the purchase of health insurance and health care, albeit in a way that grants larger subsidies to high-income households than to low-income households. (Why any legislator would structure a public subsidy this way is, of course, an ethical call anchored in the legislator’s moral values.)
How could these dual goals be achieved?
The answer is simple: The politician would propose making spending on health insurance or health care, or both, tax deductible to Americans.
Such a policy would effectively lower the after-tax price of health care to patients, who ultimately pay for health care, thereby expanding utilization of health care. This in turn would enhance the revenue booked by doctors, hospitals, the pharmaceutical industry, and other providers of health care goods and services. Thus, the first goal would be accomplished.
Under our progressive income-tax structure, tax-deductibility would automatically bestow a higher federal subsidy for a given health care good or service on higher-income households, facing high marginal tax rates, than it would on lower-income households facing lower marginal tax rates. For example, a $1,000 pre-tax medical or dental bill would cost someone facing a 50 percent marginal tax rate only $500 in after-tax dollars, while it would cost someone facing, say, a 20 percent marginal tax rate $800 in after-tax dollars. Thus the second goal would be accomplished.
The Tax Preferences Landscape
Much to the chagrin of economists, who favor a simple and clean tax system, granting tax preferences to various private-sector activities is much favored by politicians. There are different ways of doing so, however.
Tax deductibility is just another name for subsidies that favor higher-income taxpayers. By contrast, tax credits are offsets to a taxpayer’s tax bill. Their size is independent of the taxpayer’s income. They can be granted in the form of so-called “refundable tax credits” even to citizens who do not owe any taxes or to citizens whose tax bill is smaller than the tax credit, in which case the Internal Revenue Service sends the citizen a refund equal to the tax credit minus any taxes owed.
Clearly, the distributive impact of tax deductibility and tax credits are quite different. If Congress is determined to enact social policy through the tax code, economists generally prefer tax credits to tax deductibility.
The U.S. Congress’ Joint Committee on Taxation has estimated the total federal revenue loss due to tax preferences of any type for 2015 to be $1.2 trillion, or about two thirds of the combined size of the individual and corporate income tax revenue actually collected. The projected estimate for 2019 is $1.6 trillion.
The preference for tax deductibility to further social goals was revealed once more recently in presidential candidate Donald Trump’s proposal for child care support. But the idea also is widely applied in health care. Employer-paid contributions to the premiums for their employees’ health insurance, for example, can be deducted by employers as a tax-deductible business expense but are not counted, as are cash wages, in the employees’ taxable income. Deposits into tax-preferred Health Savings Accounts (HSAs) similarly are effectively tax deductible, as are medical expenses above a specified limit. In each case, the policy is regressive in the sense that it bestows a higher public subsidy on high-income households than on low-income households.
Tax Preferences Versus Spending: A Distinction Without A Difference
It is possible that politicians and other advocates of tax deductibility sincerely believe this approach to be superior to a policy of explicitly raising taxes to finance public subsidies for desired private-sector activities. Tax-and-spend policies are widely thought to retard economic growth. By contrast, in the political arena, tax deductibility can be marketed as a tax cut that encourages economic growth, certainly in the health care sector.
Economists, as well as Congress’ Joint Tax Committee, will have none of that. They view tax preferences as fully the equivalent of regular government spending financed with (1) additional taxes levied on tax payers not favored by a preference, (2) reductions in federal spending that would have bestowed benefits on citizens who may or may not benefit from the tax preference, or (3) additions to the federal debt, to be paid off with taxes from future generations of tax payers.
“Tax expenditures” are easiest explained to students in economics with the first, simplest case: tax preferences that are financed with additional taxes levied on other taxpayers. The basic assumption here is that government should operate with a balanced budget, or at least that a given tax preference should be budget neutral. If so, the revenue shortfall from the tax preference must be recouped by levying some extra taxes on taxpayers not favored by a preference. So styled, the tax preference then clearly appears as just one more tax-financed government expenditure. As the Joint Committee on Taxation succinctly puts it:
Special income tax provisions are referred to as tax expenditures because they may be analogous to direct outlay programs and may be considered alternative means of accomplishing similar budget policy objectives. Tax expenditures are similar to direct spending programs that function as entitlements to those who meet the established statutory criteria.
The argument is easily extended to instances when tax deductibility granted to some citizens is financed by cutting government benefits to others, or by shifting the burden to future generations by deficit-financing current subsidies. Future generations must repay with added taxes the accumulating public debt.
It would be easy at least to eliminate the regressive nature of tax deductibility. One simple way to do this would be to apply the same marginal tax rate—e.g., 30 percent—to all tax-deductible spending, regardless of a household’s actual marginal tax rate. In effect, it would convert tax-deductibility into a tax credit. That credit could even be means-tested if the tax preferences were desired to be progressive.
In the meantime, voters should pay closer attention to the nature of tax preferences through which politicians seek favor among voters. It remains to be seen if the TV journalists with face-to-face access to political candidates have the intellectual wherewithal to delve into so subtle an issue. In principle, it should be easy to ask any politicians proposing tax deductibility for this or that expenditure why the underlying commodity should be made cheaper for high-income households than for low-income households: Specifically, what ethical values would drive such an approach? That question might elicit some interesting responses.